11th June 2013
Below is the latest note from J.P. Morgan Asset Management’s Dan Morris who argues that we are still a long way off the target unemployment rate which should see the tapering of quantitative easing, but when it comes it will have a big impact given that the end of QE1 and QE2 saw big market falls.
After a nervous couple weeks, US equity markets reacted positively to the latest payrolls report. Outside the US, however, markets were down from the previous Friday (see table above). Some of the current market volatility could decline following the US Federal Reserve (the Fed) chairman’s press conference this month if Bernanke provides a clearer indication of timing for a tapering of the Fed’s asset purchases. The hope for certitude may be disappointed, however, as the guidance from the Fed may be: ‘It depends.’ One of the benchmarks for less aggressive monetary policy is strong employment growth and a target unemployment rate of 6.5%, but that is still a long ways off. On current trends, we forecast the unemployment rate will not hit that level until next year, and there is a wide range around the date depending on the rate of job creation and the labour participation rate (see Figure 1).
Figure 1: Fed target unemployment rate scenarios
Last data May 2013. Note: Current payrolls assumes monthly non-farm payrolls increase by 150k and participation rate is constant at 63,5%. Improving payrolls assumes increase in non-farm payroll rate to 200k/month and participation rate increases by 0,05% each month. Deteriorating payrolls assumes increase in non-farm payrolls of 100k/month and participation rate dropping by 0,05% each month. Source: BLS, US Federal Reserve, J.P. Morgan Asset Management.
Once quantitative easing (QE) ends, what is the likely impact on equity markets? To judge by the returns when QE 1 and QE 2 ended, it could be a correction of more than 10% (see purple figures in the gaps in Figure 2). Though there were certainly other factors affecting markets at the time (most notably the eurozone debt crisis), the end of QE 1 was followed by a 13% drop in the markets and QE 2 by a 14%. Consequently, a correction ahead due to the end of QE 3 is to be expected. These declines need to put in context of the market’s previous gains, however. At the end of the post-QE 2 drop, the S&P 500 had still gained nearly 70% from the March 2009 low and today it is up more than twice that. The MSCI ACWI has nearly doubled since March 2009 (price return only). As we have previously noted, there are enough other factors supporting equity markets (earnings growth, valuations, investor sentiment, liquidity), to believe that any retrenchment will be followed by renewed (albeit slower) price appreciation.
Figure 2: QE, equity index returns, and Treasury yields
Last data 7 June 2013. Values at top of chart show trough-to-peak or peak-to-trough price return for S&P 500. Source: BLS, US Federal Reserve, J.P. Morgan Asset Management.
Equity markets, of course, have not been the only victims of recent QE uncertainty. The long-predicted and feared bond market reset may have begun. Returns for every major sector of the bond market are negative from the end of April (see Figure 3).
Figure 3: Fixed income index total returns since 30 April 2013
Last data 7 June 2013. *Total return in local currency/hedged terms.
Source: Barclays, Bloomberg, J.P. Morgan Asset Management.
A slowdown (or anticipation of a slowdown) in QE does not necessarily mean that yields have to rise significantly, however. This is because QE is not the only factor that has driven them so low. Besides the positive impact on equities from QE liquidity, Figure 2 also shows that the relationship between QE and US Treasury yields is not so straight forward. During the first two rounds, yields largely rose despite the increased demand for Treasuries from the Fed, and yields were already quite low when QE 3 began and have generally remained so.
The reason for the poor relationship is that other drivers of fixed income yields have played a more important role than QE, and most of these factors argue for higher yields ahead, regardless of what happens with the Fed. Sentiment about Europe (or at least the euro) is clearly much better today than it was during the worst of the eurozone crisis. The negativity that drove demand for safe haven assets was partly replaced by worries about the fiscal cliff and sequestration in the US, but these are also fading.
If attitudes towards risk are improving, the outlook for growth is more mixed. Economists expect GDP growth to recover from 2.0% in 2013 to 2.7% by next year in the US, so real yields should rise. The UK and eurozone will also see stronger growth but as it is forecasted to be just 1.5% in the UK and 0.7% for the eurozone, the pressure for higher yields will not be as strong.
Fortunately, inflation expectations remain well anchored thanks to investors’ belief that central bankers will tighten if inflationary pressures begin to rise (see Figure 4). This seems unlikely in the short term as unemployment remains high. Credit growth bears watching, however, as the excess liquidity in the US could yet translate into sufficiently strong demand such that prices are pushed up. Currently, growth in bank lending to corporates is running at an above average rate (in real terms) but it is slowing, while consumer borrowing is declining for revolving credit (such as credit cards), and is moderate for mortgages and the like.
Figure 4: Inflation expectations
Last data 7 June 2013. Source: Barclays, Bloomberg, J.P. Morgan Asset Management.